It is not uncommon for affiliated
groups that file a consolidated U.S. federal
income tax return (U.S. consolidated groups)
to have gain that has been deferred under the
intercompany rules for U.S. consolidated
groups. This item illustrates how transfers of
items outside a U.S. consolidated group can
trigger a deferred intercompany gain (DIG) and
suggests ways to avoid that result in certain
situations.

Example 1: USS, a U.S. corporation, distributes stock
of a foreign subsidiary FS1 to USP, USS’s parent corporation, in a distribution
not qualifying under Sec. 355. The
distributed stock (BIG stock) has a
built-in gain. USP then
contributes the BIG stock to FS2, a
foreign subsidiary of USP, in an exchange qualifying under Sec.
351. USS and USP are members of the same U.S.
consolidated group; FS2 is not a member of the
group.

Intercompany
Rules Generally

Under Sec. 311(b),
when a corporation distributes appreciated
property, the corporation generally is
required to recognize gain built into the
property as if such property were sold to the
distributee at its fair market value (FMV).
However, there is an exception to the general
rule for transactions between corporations
that are members of the same U.S. consolidated
group immediately after the transaction
(intercompany transactions).
Generally, any gain realized on an
intercompany transaction is deferred in
determining the U.S. federal income tax
consequences to the selling member until it is
required to be included in income under either
the matching rule of Regs. Sec. 1.1502-13(c)
or the acceleration rule of Regs. Sec.
1.1502-13(d).

In the example transaction,
USS
and USP are
members of the same U.S. consolidated group
immediately after the distribution of the BIG
stock from USS to
USP;
therefore, the distribution is an intercompany
transaction. Consequently, the gain built into
the BIG stock will become a DIG, which should
be deferred until the matching rule or the
acceleration rule requires it to be included
in income.

The
Acceleration Rule

Under the
acceleration rule, the intercompany items of a
selling member (S) are
taken into account immediately before the
items can no longer be taken into account to
produce the effect of treating S and the
buying member (B) as
divisions of a single corporation. Regs. Sec.
1.1502-13(d)(1)(i) explains that, for this
purpose, the effect cannot be achieved to the
extent a nonmember reflects, directly or
indirectly, any aspect of the intercompany
transaction, e.g., if
B’s cost basis in property
purchased from S is
reflected by a nonmember under Sec. 362
following a Sec. 351 transaction.

An
outbound transfer could trigger the
recognition of a DIG under the acceleration
rule when, for example, the transfer results
in a nonmember’s reflecting basis that
resulted from an intercompany transaction.
Consider the example transaction: USP would
take an FMV basis in the BIG stock under Sec.
301(d) when USS
distributes the BIG stock to USP. When
USP
then contributes the BIG stock to FS2 in a
Sec. 351 exchange, FS2—which
is not a member of the U.S. consolidated
group—would receive the BIG stock with a
carryover basis under Sec. 362. Thus, the
stepped-up basis resulting from the
intercompany transaction would be reflected in
a nonmember, thereby triggering the DIG that
resulted from the earlier distribution from
USS
to USP.

This result may be avoided, however, if the
outbound transfer is structured as an asset
reorganization under Sec. 368, rather than a
contribution of stock under Sec. 351. In the
example transaction, the parties could, for
instance, check the box to treat FS1 as a
disregarded entity for U.S. federal income tax
purposes after the contribution to FS2.
Because FS1 would
be disregarded for U.S. federal income tax
purposes, the transfer would then be treated
as an asset transfer, which could qualify as a
reorganization under Sec. 368(a)(1)(D) (a D
reorganization). Pursuant to Sec. 358, the
basis in the BIG stock would be reflected in
USP’s basis
in FS2, rather
than in FS2’s
interest in FS1. In
other words, the basis from the intercompany
transaction would remain in the U.S.
consolidated group (i.e., it
would not be reflected in a nonmember), and
the acceleration rule would not trigger the
DIG.

This method should allow the
taxpayer to avoid triggering the DIG under the
acceleration rule even if the assets are
transferred to a lower-tier subsidiary, as may
be desired. To illustrate, consider this
“restructured” example transaction:

Example 2: Begin with the facts of the transaction
in Example 1 and assume that after USP contributes the BIG stock to FS2, FS1 makes a check-the-box election to be
treated as a disregarded entity. Then FS2 contributes its interest in FS1 to FS3, a wholly owned subsidiary of FS2.

The restructured
example transaction could still qualify as a D
reorganization, but with a drop under Regs.
Sec. 1.368-2(k). The stepped-up basis in the
BIG stock would still be reflected only in
USP’s basis
in FS2. FS2’s basis
in FS3 would
reflect only the basis of the inside assets of
FS1.
Therefore, the basis from the intercompany
transaction would not be reflected in a
nonmember, and the acceleration rule would not
trigger the DIG.

The
Matching Rule

Sidestepping the
triggering of a DIG under the acceleration
rule does not, however, end the analysis.
Although the restructured transaction in
Example 2 avoids application of the
acceleration rule, it could still trigger
recognition of a DIG under the matching
rule.

Under the matching rule, the
separate entity attributes of S’s
intercompany items (i.e., S’s income,
gain, deduction, and loss from an intercompany
transaction) and B’s
corresponding items (i.e., B’s income,
gain, deduction, and loss from an intercompany
transaction, or from property acquired in an
intercompany transaction) are redetermined to
the extent necessary to produce the same
effect on consolidated taxable income as if
S
and B
were divisions of a single corporation, and
the intercompany transaction were a
transaction between those divisions.

B takes its corresponding items into
account under its accounting method, but the
redetermination of attributes of a
corresponding item might affect its timing. S takes its intercompany item into
account to reflect the difference for the
year between B’s corresponding item taken into account
and the recomputed corresponding item (i.e., the corresponding item that B would take into account if S and B were divisions of a single corporation
and the intercompany transaction were
between those divisions). Regs. Sec.
1.1502-13(b)(4) explains that “[a]lthough
neither S nor B actually takes the recomputed
corresponding item into account, it is
computed as if B did take it into account (based on
reasonable and consistently applied
assumptions, including any provision of the
Internal Revenue Code or regulations that
would affect its timing or attributes).”

An outbound transfer could
trigger the recognition of a DIG under the
matching rule when the transfer would have
given rise to gain if S and B were
divisions of a single corporation,
e.g., under Sec. 367. Under Sec.
367(a), if a U.S. person transfers property to
a foreign corporation in connection with an
exchange described in Sec. 332, 351, 354, 356,
or 361, the foreign corporation is not
considered a corporation for purposes of
determining gain recognized on the
transaction. These specified Code sections
require the transferee to be a corporation for
U.S. federal income tax purposes to obtain
nonrecognition treatment. Thus, the
application of Sec. 367(a) results in gain
(but not loss) recognition.

Regs. Sec.
1.367(a)-3(a)(2)(ii) provides an exception to
Sec. 367(a) for certain asset reorganizations.
However, this exception does not apply when
the reorganization is treated as an “indirect
stock transfer” under Regs. Sec.
1.367(a)-3(d). Regs. Sec.
1.367(a)-3(g)(1)(iv)(B) indicates that a D
reorganization followed by a “controlled asset
transfer” is treated as an indirect stock
transfer. A controlled asset transfer occurs
when the corporation acquiring assets in the
asset reorganization transfers all or a
portion of the assets to a corporation
controlled (within the meaning of Sec. 368(c))
by the acquiring corporation as part of the
same transaction. Under this provision, the
restructured example transaction in Example 2
should be treated as an indirect stock
transfer; therefore, the restructured
transaction generally would be subject to Sec.
367.

As discussed above, USP, which
functions as B for the
purposes of applying the matching rule, would
have taken an FMV basis in the BIG stock under
Sec. 301(d) when USS
distributed the BIG stock to USP.
Therefore, when the BIG stock is then
transferred to FS2, it
would have basis equal to value. Because there
would not be any gain built into the BIG stock
at that time, this transfer would not give
rise to any gain under Sec. 367. This zero
gain/loss actually realized would be B’s
corresponding item for the purposes of
applying the matching rule.

However,
the matching rule requires that one determine
the gain that would have resulted had S and B been
divisions of a single corporation. In the
restructured transaction in Example 2, if
USS
(which functions as S for the
purposes of applying the matching rule) and
USP
were divisions of a single corporation, Sec.
301(d) would not have caused USP to take
an FMV basis in the BIG stock when USS
distributed the BIG stock to USP,
because the distribution would be disregarded.
Therefore, when the BIG stock is then
transferred to FS2, it
would have built-in gain. This transfer could
therefore trigger the gain built into the BIG
stock under Sec. 367. This gain would be USP’s
recomputed corresponding item.

Thus, if the taxpayer were to undertake
the restructured transaction in Example 2,
the matching rule would require the U.S.
consolidated group to take its DIG into
account to reflect the difference for the
year between the zero gain/loss actually
taken into account under Sec. 367 and the
fictional gain that would have been taken
into account under Sec. 367 if USS and USP were divisions of a single corporation.

This result may be avoided as
well, however, by using a gain recognition
agreement (GRA). When a U.S. person transfers
stock or securities of a foreign corporation
to another foreign corporation and is a 5%
shareholder of the transferee foreign
corporation, Regs. Sec. 1.367(a)-3(b)(1)
provides an exception to the Sec. 367(a) rule
where the taxpayer enters into a five-year
GRA. The GRA functions to defer gain unless
and until it is triggered by a gain
recognition event specified in Regs. Sec.
1.367(a)-8. If the gain is later triggered,
the U.S. transferor must include in income the
gain realized but not recognized on the
initial transfer by reason of entering into
the GRA. Under Regs. Sec.
1.367(a)-8(c)(1)(iii), a U.S. transferor must
either report any gain recognized on an
amended U.S. federal income tax return for the
tax year of the initial transfer or elect to
include any gain recognized in the tax year
during which a gain recognition event occurs.
In either case, Regs. Sec. 1.367(a)-8(c)(1)(v)
requires the payment of interest on any
additional tax due with respect to gain
recognized by the U.S. transferor.

If
the fictional transaction under which B’s
recomputed item is calculated is of the sort
to which the GRA exception would have applied
if the transaction had actually occurred (as
would be the case in the Example 2
restructured transaction), arguably, the
taxpayer should likewise be able to qualify
for the exception by filing a GRA based on the
fiction. This would seem to be the sort of
“reasonable and consistently applied
assumption, including any provision of the
Internal Revenue Code or regulations that
would affect [the] timing or attributes [of a
recomputed item]” that Regs. Sec.
1.1502-13(b)(4) explicitly allows taxpayers to
apply in calculating their recomputed
items.

The GRA would defer the fictional
gain, so that B’s
recomputed item would be zero gain/loss. The
DIG should remain deferred as well, unless and
until Regs. Sec. 1.367(a)-8 would apply to
trigger the fictional gain that was deferred
under Sec. 367 (or the DIG is otherwise
triggered under the intercompany rules).

Note that, to maintain the appropriateness
of this method, a taxpayer filing a GRA based
on the application of Sec. 367 to its
recomputed item calculation should not elect
to include any gain recognized in the tax year
during which a gain recognition event occurs,
because there does not appear to be a
mechanism to require a taxpayer whose DIG is
triggered by a gain recognition event under
Sec. 367 to pay interest, unless the taxpayer
is required to amend a prior return. Although
it is appropriate that a taxpayer be in the
same position that it would have been in had
its recomputed item been real, it is not
appropriate that the taxpayer be in a better
position than it would have been in had its
recomputed item been real, as would be the
case if the taxpayer were not required to pay
interest when the gain is later triggered.

The winner of The Tax Adviser’s 2014 Best Article Award is James M. Greenwell, CPA, MST, a senior tax specialist–partnerships with Phillips 66 in Bartlesville, Okla., for his article, “Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations.”

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